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Concept and determinants of liquidity and solvency of commercial banks



Category: Concept of the Bank and the Banking System

Liquidity — one of the distributions of quality characteristics of the bank, which is responsible for its reliability. Bank liquidity — the ability to promptly and without loss to meet their obligations to depositors and creditors.

The bank’s liabilities consist of the actual and potential. Real commitments are reflected in the bank’s balance sheet in the form of demand deposits, time deposits, interbank resources of creditors. Contingent liabilities primarily expressed in the passive off-balance sheet operations of banks (such as warranties and guarantees issued by the bank), as well as active off-balance sheet transactions (unused credit lines of the letters of credit, etc.). This group of bank liabilities should be classified and timely satisfaction of customer needs to obtain new loans without credit lines. Implementation of the client’s request means that the bank is able to efficiently provide themselves with the necessary resources,

Sources of funds to meet liabilities are cash bank balances denominated in cash on hand and on correspondent accounts (in the Central Bank and other commercial banks) assets that can quickly turn into cash, interbank loans, which if necessary can be obtained from the interbank market or from the Central Bank.

Using these sources should not be accompanied by a loss to the bank, ie to turn around losses. For example, the sale of securities or other assets as the source of the appearance of liquid assets should be carried out normally at pre-negotiated terms of price and terms.

But the presence of these two attributes the bank’s liquidity (the timeliness of implementation of commitments and no losses) is determined by many factors, internal and external order, determining the quality of the bank.

Among the factors internal order are: a strong capital base of the bank, the quality of its assets, the quality of deposits, reasonable reliance on external sources, the conjugation of assets and liabilities by maturity, good management, excellent image of the bank.

Strong capital base of the bank means that there is a significant absolute value of equity as the main source of protective absorption of risk assets and the guarantee of depositors and creditors. The basis of the share equity fund and other funds of the bank, for different purposes, including to ensure financial sustainability of the bank. The greater the bank’s own capital, the higher its liquidity.

Another factor affecting the liquidity of the bank, is the quality of its assets.

Quality of assets is determined on the basis of four criteria: liquidity, risk, profitability and diversification. Liquidity of assets — the ability to transform assets into cash through their sale or repayment by the debtor (borrower). Degree of liquidity of assets depends on their destination. Assets of the bank, located in monetary form, are designed to perform billing functions. Loans can meet the short and long term needs of clients. Similarly, investments in securities and other investments.

In this regard, the degree of liquidity of bank assets are divided into several groups:

The first group consists of first-rate liquid assets, which include:

a) direct cash bank in his or her office or correspondent accounts;

b) government securities held in the portfolio of the bank, to the realization that he may have recourse in the event of insufficient cash to meet obligations to creditors.

Maintaining the volume of the first group of assets at a certain level is an essential condition to ensure the liquidity of the bank.

The second group of assets by the degree of liquidity are short-term loans to businesses and individuals, interbank loans, factoring, commercial paper corporations. They have a longer period of transformation in cash.

The third group includes long-term investment assets and investment bank, including long-term loans, leases, investment securities.

Finally, it should allocate the fourth group of bank assets, which includes illiquid assets in the form of overdue loans, some types of securities, buildings and structures.

Riskiness as a criterion for the quality of assets means the potential loss of their transformation into money. The degree of risk assets is dependent on many factors specific to certain of their kind. For example, the risk of loans due to the financial condition of the borrower, the contents of an object credit, loan volume, the order of issuance and redemption, etc. Risk of investing in a security depends on the financial stability of the issuer, the mechanism of production and sales of securities, the ability to be quoted on the stock exchange, etc.

By the degree of riskiness of bank assets are also divided into several groups.

Classification of assets according to risk and the risk of each asset group is mixed in different countries and for different purposes. To assess the adequacy of capital used in international practice recommendations of the Basel Agreement, under which there are four groups of assets. Current practice for this purpose involves the division into five groups. To assess the quality of the loan portfolio of the Central Bank recommends the allocation of the four groups of loans with the definition of different levels of risk.

Regardless of the specific practices of different countries, the classification of assets under this criterion, there is one fundamental position to establish the dependence of the bank’s liquidity on the riskiness of assets. The higher overall risk of bank assets, the lower the liquidity of the bank.

Return on assets as a criterion of their quality reflects the efficiency, effectiveness assets, ie, ability to earn income and thus create a source for the bank’s development and to strengthen its capital base.

By the degree of yield assets are divided into two groups: income and non-profit. The higher the share of assets, income, the ceteris paribus more income (profit) has a bank, and hence more opportunity to strengthen its capital base. This means that the bank can withstand more risk, which he himself took.

However, in the management structure of their assets by degree of profitability should maintain a reasonable, since unrestrained pursuit of profit can result in loss of assets and loss of liquidity.

Criterion for the quality of assets may serve, and their diversification. showing the degree of resource allocation to different areas of the bank’s placement. Indicators of diversification of assets are: the structure of bank assets in the main areas investment of resources, the structure of credit investments on the subject and object, the structure of the portfolio of securities, currency, from which the bank foreign currency transactions, the structural composition of banks with whom the bank has established correspondent, deposit and credit relationships.

The more variable assets, the higher the bank’s liquidity.

An important factor in determining the degree of liquidity, is the quality of its deposit base. Deposit base form of legal and natural persons, accumulated by the bank as a means of settlement and current accounts, time deposit and savings deposits. Criterion for the quality of deposits (demand, term and savings) is their stability. The more stable part of the deposit, the higher the liquidity of the bank, because in this part of the accumulated resources do not leave the bank. Increase the stability of bank deposits reduces the need for liquid assets, as it implies renewability of bank liabilities.

Analysis of the status of various types of deposits held by foreign researchers, showed that the most stable have deposits. This kind of deposits does not depend on the level of interest rates. It belongs to a particular bank to a greater extent due to factors such as quality and speed of service, reliability of the bank, a variety of services offered to depositors, the proximity of the bank from the customer. Therefore, the opening of a settlement or a bank account that meets these requirements, the client establishes a longstanding relationship with the bank systematically spending and adding to funds in the account.

Less stable, according to a survey of foreign researchers, have remnants of term and savings deposits. Their tightness for a specific bank has a major impact rate of interest. Therefore, they are subject to migration in the case of certain fluctuations in the level of deposit interest to be determined by different banks.

The bank’s liquidity is also conditioned by its dependence on external sources, which are inter-bank loans.

Interbank loan within a certain range does not pose a threat to liquidity, on the contrary, it eliminates the short-term lack of liquidity. If the interbank credit is the main place in leveraging resources, unfavorable situation on the interbank market may lead to the collapse of the bank. Bank, featuring a heavy dependence on external sources, has no basis for the business, he has no prospects for development and subject to significant risk of instability of its resource base.

Serious impact on the liquidity of the bank has contingency assets and liabilities on the amounts and dates. Implementation of Bank obligations to the client assumes the timing, which invested the funds with those that are provided to investors. Failure to do so in the bank, working primarily on leveraging resources, will inevitably lead to the impossibility of timely and full implementation of bank obligations to creditors. Of course, that not all deposits are removed at the same time, some of them resumed, but the main portion of the assets and liabilities, compliance with this rule for certain.

The internal factors that determine the degree of liquidity, is also management, ie System management of the bank’s overall liquidity and, in particular. The quality of bank management expressed in the presence and content of banking policy, a rational organizational structure that allows high-level strategic and solve current problems and in developing an appropriate mechanism for asset and liability management, to clearly define the content of the various procedures, including those relating to the adoption of the most critical solutions.

High level of management requires a skilled, providing the necessary information base and, more importantly, understanding the bank’s management the importance of creating a scientific system of management of the bank.

Among the factors contributing to ensuring adequate liquidity, is also its image. Positive image of the bank allows him to have advantages over other banks in attracting resources and thus more quickly bridge the liquidity needs. Bank with a good reputation is easier to ensure the stability of its deposit base. He has more opportunities to establish contact with a financially stable customers, and therefore have higher asset quality.

First-class image of the bank allow him to develop ties with foreign partners, which also contributes to the strengthening of its financial condition and liquidity.

Forming a positive image of the bank, if it is based on actual results achieved, there is a complex process, involving the correct choice of strategy development, improve the quality of customer service; deepening market research, the organization of credible, systematic and general advertising, public relations, ensuring transparency of information about their activities, including through the publication of reports, etc.

The credibility of the bank due, and ratings by independent rating agencies and published and in print.

The positive image is largely determined by personal qualities of senior managers, their competence and morality. Bank wishing to emergencies quickly and easily restore their liquidity, should be actively and purposefully engaged in the formation of a positive image.

The above-considered factors contributing to the liquidity of the bank, get a greater or lesser importance depending on the individual bank’s financial condition of the founder, the specifics of a bank’s range of clients, expertise, length of the bank, the quality of the management team, etc.

In some cases, the problem of liquidity of the bank can create the structure and quality of the resource base, in others — as assets in the third — management, and in some cases — and the complex of factors.

Therefore, recognizing the multifactor problem of liquidity of the bank, it is also important to take into account his personality, highlight its main «pain» points of concern to the bank’s most significant.

As noted above, the liquidity position of banks is also dependent on a number of external factors that lie outside of banking. These include: the general political and economic situation in the country, the development of securities market and the interbank market, the organization of the refinancing, the effectiveness of the oversight functions of the Central Bank.

The overall political and economic situation in the country creates preconditions for the development of banking operations and the success of the banking system, ensures the stability of the economic foundation of banks, strengthen the confidence of domestic and foreign investors in banks. Without these conditions banks will not be able to create a stable deposit base and achieve profitability of operations, develop our own tools to improve the quality of their assets, improve system management.

Securities market development ensures the most optimal option to create liquidity without sacrificing profitability, as the fastest way to becoming the bank’s assets into cash in most foreign countries is related to the functioning of the stock market.

The development of the interbank market contributes to the rapid redistribution between the banks of temporarily free money resources. On the interbank market to maintain its liquidity the bank can raise funds for various periods, including a single day. Efficiency of obtaining funds from the interbank market depends on the overall financial environment, the organization of the interbank market, the credibility of the bank.

With this factor is closely related to the other — the system of refinancing by the Central Bank, commercial banks. Through its source of replenishment of liquid assets of commercial bank credit is the Central Bank. The effectiveness of the oversight functions of the Central Bank determines the degree of interaction between the body of state oversight of commercial banks in terms of liquidity management. CB has the ability to set certain standards of liquidity, banks focusing on their compliance. The higher the figures reflect the true state of bank liquidity, the greater the possibility of the bank itself and the supervisor time to identify problems with liquidity and eliminate them.

Thus, liquidity is a qualitative description of the bank’s activities, due to many factors, which are in constant change and relationships.

Therefore, the bank’s liquidity is a dynamic state, which develops gradually and is characterized by the influence of various factors and trends. Along with the terms «liquidity» of the bank, in literature and in practice, the term solvency of the bank. Approach to content analysis of a second concept in different countries has been mixed.

The materials of the World Bank’s ability to pay is associated with a positive value of bank equity, the capital with a minus sign «means a bank failure. At this interpretation is based on the solvency of the bank’s capital as a guarantee fund covering its obligations.

In other countries, solvency of the bank determine capital adequacy in relation to risk assets.

The economic literature solvency seen as a more general and a more narrow category in relation to the bank’s liquidity. In the case of the perception of it as a more general category, it is considered in the complex internal and external factors affecting this state, and liquidity — from the perspective of internal factors.

But the most common point of view determines the liquidity of the bank as a dynamic state, reflecting the ability to timely fulfill liabilities to creditors and investors by managing their assets and liabilities. In contrast to the solvency of the bank’s liquidity is considered in the aspect of the performance of a specific date of all obligations, including financial, for example, the budget for taxes, to employees for wages, etc. At this interpretation of the criterion of the bank’s liquidity is a contingency of all its assets and liabilities on the terms and amounts, in the case of a mismatch — the ability to provide themselves with liquid assets. The criterion of ability to pay appears sufficient for a specific date of correspondent accounts to make payments, including from the profits of the bank.

This relation between liquidity and solvency problems in practice leads to the fact that under this definition, the liquidity and solvency of the bank can not do at certain periods of its payment obligations, but to stay liquid, loss of liquidity also implies a systematic inability to pay.

Insolvency resulting from the loss of liquidity, means, firstly, the inability to find bank’s internal sources to repay their obligations, and secondly, the inability to attract for this purpose from external sources.


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